ESG Integration Flashcards
An investment firm may have several different aims and objectives for integrating ESG into an investment process, name them?
A. meeting requirements under fiduciary duty or regulations;
B. meeting client and beneficiary demands;
C. lowering investment risk;
D. increasing investment returns;
E. giving investment professionals more tools and techniques to use in analysis;
F. improving the quality of engagement and stewardship activities; and
G. lowering reputational risk at a firm level and investment level.
United Nations Environment Programme Finance Initiative (UNEP FI), along with legal firm Freshfields and the United Nations Principles for Responsible Investment (UN PRI), analysis (across jurisdictions) argue that the fiduciary duties of investors require them to:
- Incorporate ESG issues into investment analysis and decision-making
processes, consistent with their investment time horizons. - Encourage high standards of ESG performance in the companies or other entities in which they invest.
- Understand and incorporate beneficiaries’ and savers’ sustainability-related preferences, regardless of whether
these preferences are financially material.
Is ESG analysis quantitative or qualitative?
Either or…or even both at times.
How is Qualitative and Quantitative ESG Analysis typically utilized?
Qualitative likely used in investment processes that is based on company-specific research, fundamental analysis, and stock-picking:
A. Investment teams analyse ESG data to form their opinion on the ability of the firm to manage certain ESG issues.
B. They combine this opinion with their financial analysis by linking specific aspects of the company’s ESG risk management strategy to different value drivers (such as costs, revenues, profits and CapEx requirements).
C. Analysts and portfolio managers then seek to integrate their opinion in a quantified way in their financial models by adjusting assumptions used in the model, such as growth, margins or costs of capital.
Quantitative usually in quant models where they can factor in an ESG score alongside other factors such as size, momentum, growth, volatility, etc.
Different types of systematic investing aka quant trading…
- High frequency
- Algorithmic
- Trend based
- Risk Parity
- Beta Strategies
The approach tends to use heavy mathematical modelling, computing power and data analysis potentially including machine and natural language learning processes. Some firms solely use these approaches and some
use them to supplement human decision-making.
Different types of internal ESG research fall into what categories/methods?
» materiality frameworks; » ESG-integrated research » dashboards » strengths, weaknesses, opportunities and threats (SWOT) analysis with ESG factors » scenario analysis » relative rankings
Describe the difference between a company ESG analysis and a security/bond ESG assessment of that same company?
A company analysis typically examines fundamental properties of a business, such as its competitive advantages (or lack of), These properties could appear in the company’s products or services, suppliers, employees,
management, organisational structure, incentives, corporate cultures or its resources (natural, intellectual or innovation). Many of these properties could be considered as under an ESG category.
While stocks and bonds can have properties that companies do not, such as stock beta or volatility, which are potentially expressed in different ways.
What are the different methodologies used for the gathering of ESG information at the Research stage of ESG assessment?
Gathering company and financial information from different sources including but not limited to 3rd party sources, company reports, questionnaires, mgmt interviews, emissions data.
Materiality assessment to identify ESG issues that are likely to have an impact on company financial performance. Materiality should be measured in terms of both likelihood and magnitude of impact and is important to note that there is evidence to support that non-material factors do not impact financial/company performance.
Evaluation of Tangible vs Intangible factors
What is one framework for evaluating different forms of ‘capital’ or tangible or intangible factors?
International Integrated Reporting Council (IIRC) - certain companies report to, acknowledges the following forms of both tangible and intangible capital:
Financial Manufactured Human Intellectual Social/relationship Natural
Note that many of the non-financial capitals would be considered under ESG, with a large number also intangible.
From an ESG perspective, how can investors generate ideas?
By looking at data and incorporating a screen or multiple ESG factors to narrow down universe of acceptable investments. Essentially best in class investing or positive screening. Another starting point is thematic investing.
From here, incorporating any material red flags that my exist. This could be quantitative ( e.g. carbon intensity) or qualitative (e.g. experience of mgmt team)
One way to take a qualitative judgment of a factor and put a form of quantitative score on it? How do you develop a scorecard?
Scorecards…ESG ratings agencies may provide scores and a form of scoring is typically used in commercially available ESG ratings services. These can be used raw or adjusted by practitioners to reflect their own views.
These scores can then be compiled for use in assessment or idea generation. The scorecard technique could be used on private companies as well public companies. (Challenges to creating
private company scorecards is that there is less likely to be a rating agency score for a private company,)
summary, to develop a scorecard:
1. Identify sector or company specific ESG items.
2. Breakdown issues into a number of indicators (e.g. policy, measures, disclosure).
3. Determine a scoring system based on what good/best practice looks like for each indicator/issue.
4. Assess a company and give it a score.
5. Calculate aggregated scores at issue level, dimension level (environmental, social or governance level) or total
score level (depending on the relative weight of each issue).
6. Benchmark the company’s performance against industry averages or peer group (optional).
Name the two types of material ESG risk…?
1) Unmanageable risk: Risk that can not be addressed by mgmt
2) Management Gap: Represents risk managed by a company through suitable initiatives but has not been implemented yet.
How does one determine which ESG issues are material to a company or sector?
No consistent method because it is not an exact science, and there might be important differences between what each investor considers most material, even when analysing the same company.
This is because it is typically a forecast of judgment on how much one ESG or risk factor will impact a financial metric such as future cash flow.
After the research stage and any relevant risk and materiality mapping, practitioners assess the impact of material financial and ESG factors on the corporate and investment performance of a company.
This can lead to what adjustments in valuation?
▶ forecasted financials;
▶ valuation-model variables, such as cost of capital or terminal growth rates in discounted cash flow analysis;
▶ valuation multiples;
▶ forecasted financial ratios;
▶ internal credit assessments; and
▶ assumptions in qualitative or quantitative models.
Example)
For example, a company’s environmental management processes and policies are judged strong or weak. After this judgment, the cost of capital used to discount cash flows in a DCF analysis is adjusted down or up by 1% to account for this. This can also be on a country- or sector-basis, where a country or sector ESG risk factor may contribute to a change in a cost of capital or terminal value growth assumption. For example, the coal sector
may be judged to have a negative environmental impact.
Besides valuation adjustments, name other practices that may be utilized?
- adjustments can be made directly to the balance sheet or capital expense lines.
- explicit sales or margin assumptions may be adjusted.
- adjustments to PE ratios
- adjustments to traditional financial analysis:
Example)
The judgment of an intangible ESG factor, such as employee relations, complements an analysis of customer satisfaction and the assumptions that lead into a model of sales growth (a traditional financial factor).
→ high customer satisfaction (judged by high net promoter score);
→ higher sales growth than competition;
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